Getting Convicted of Tax Evasion Means No Discharge of the Tax in Bankruptcy

I wrote last spring about how a conviction for filing a false tax return, IRC 7206(1), provided a basis for denying a bankruptcy discharge on the basis of collateral estoppel. The recent decision in United States v. Wanland provides an example of a conviction for tax evasion, IRC 7201, which creates the same result.

At issue in the Wanland case is only the unpaid taxes and not the fraud penalties. The civil fraud penalty, like all tax penalties, can be discharged in a bankruptcy case when it becomes three years old, as discussed here. The IRS does not argue that anything keeps the fraud penalty from discharge but it does make good use of an argument regarding its levy to extend the years in which Mr. Wanland was charged with criminal behavior to earlier years to also prevent their discharge.

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Mr. Wanland was an attorney. The recently decided case seeks to obtain a judgment against him for $1,065,493.30. He is representing himself in this litigation. On September 26, 2013, he was convicted of 28 counts of criminal tax violations. One count of 7201 evasion of payment, 24 counts of concealment of property subject to levy and three counts of 7203 failing to file tax returns.

Before he was convicted of the criminal tax violations, Mr. Wanland filed bankruptcy and received a discharge of his debts on June 8, 2011. Because of the bankruptcy discharge, Mr. Wanland argues that the IRS is collaterally estopped from raising the issue of his liabilities since it did not bring an action in the bankruptcy case to except his liabilities from discharge. The issue presented is one of first impression in the 9th Circuit though other courts have addressed it. Must the IRS affirmatively seek a determination regarding the discharge of taxes or does the exception to discharge of 523(a)(1), except the described taxes from discharge without the need for affirmative action.

The IRS takes the position that it does not affirmatively need to bring an action in each bankruptcy case to have the bankruptcy court make a determination regarding which taxes are and which taxes are not discharged. At the conclusion of each bankruptcy case the IRS makes its own determination regarding the impact of the discharge on the taxpayer’s liabilities. If the IRS determines that the taxes or penalties, were discharged, it will write them off its books and the taxpayer does not need to do anything to request that the IRS do so. If the IRS determines that the taxes are not discharged, it sends them back into the collection stream. If a taxpayer thinks that the IRS decision to send the taxes back into the collection stream is wrong, the taxpayer can sue the IRS for violating the discharge injunction and cause the write-off of the taxes if it wins.

Here, the IRS has gotten to the point in the collection of the liabilities against Mr. Wanland that it is bringing a suit to reduce the liabilities to judgment. That will cause the liabilities to hang around his neck basically forever, as we have discussed here. In his effort to ward off the suit, he argues that the IRS missed the time to object to the discharge of his tax liabilities and it cannot seek to collect them at this point.

The district court rejects his arguments citing to the decisions of other courts that have faced this issue.

“Debts listed in sections 523(a)(2), (a)(4) and (a)(6) are automatically discharged in bankruptcy unless a creditor objects to their dischargeability by fiing an adversary proceeding. Fed. R. Bankr. P. 4007 (advisory committee notes). A creditor who wishes to object to the dischargeability of a debt under sections 523 (a)(2), (a)(4) or (a)(6), must file a complaint within sixty (60) days of the first scheduled meeting of creditors. Fed. R. Bankr. P. 4007(c)… Those debts excluded from discharge not listed in sections 523 (a)(2), (a)(4) or (a)(6), including certain tax debts, are automatically excepted from discharge… As a result, a complaint to determine the dischargeability of a debt, other than a debt listed in sections 523(a)(2), (a)(4) or (a)(6), may be filed at any time. Fed. R. Bankr. P. 4007(b)”

Quoting In re Walls, 496 B.R. 818, 825-26 (N.D. Miss. 2013)(citation omitted); see also In re Range, 48 Fed. App’s 103 at 5 & n.2 (5th Cir. 2002)(unpublished).

There are 19 subparagraphs of Bankruptcy Code section 523. Only three of them have been singled out in the Bankruptcy Rules to require the creditor to affirmatively bring an action early in the case to determine discharge. The first two deal with types of fraudulent activity by the debtor and the third with willful and malicious action that causes harm. Because the particular provision that prevents Mr. Wanland’s discharge is a type of fraud, there is some basis for looking at taxes excepted from discharge under 523(a)(1)(C) to determine if they create a different situation that “ordinary” taxes. It would create an enormous burden on the IRS and the bankruptcy court to have the IRS objecting to discharge in every bankruptcy case in which the debtor’s taxes are excepted from discharge because the volume would be enormous. The IRS has historically been a creditor in about 40% of all bankruptcy cases meaning that these types of motions would be filed in hundreds of thousands of cases each year.

The number of cases in which the IRS excepts the taxes from discharge under 523(a)(1)(C), however, is quite small. It would not place a big burden on the IRS or the bankruptcy court if the IRS were required to come into those cases with a motion similar to the motion made in the cases of the three provisions cited. Nonetheless, the general rule regarding tax debts prevails here and the district court finds with the other courts looking at the issue that the IRS need not affirmatively file an objection to the discharge of this debt.

The decision does not surprise me. Once the IRS gets past the issue of whether it should have raised the issue during the proceeding, the court has no trouble finding that the debtor’s conviction serves to estop the debtor from arguing that the liability is excepted from discharge for the years of the 7201 criminal conviction which were 2000-2003. The court finds it a closer question whether the IRS can use offensive collateral estoppel to the 1996-1998 tax liabilities which were not included in the criminal case. The IRS presented evidence that it served a levy to collect taxes for 1996-1998 and 2000-2003. That levy was the levy upon which the criminal case was based because he concealed his assets to keep the IRS from receiving payment on that levy. Under the circumstances, the court finds that affirmative collateral estoppel works to prevent Mr. Wanland from arguing that the taxes for all of the years are not excepted from discharge. This is an interesting extension of the collateral estoppel effect of the bankruptcy case. The court could have reached the same conclusion without the need for collateral estoppel if it found that he was trying to evade the payment of his taxes for the non-criminal years.

 

Trying to Limit a Federal Tax Lien through Confirmation of a Chapter 13 Plan

A Chapter 13 plan usually gets confirmed with 60 to 90 days after a debtor files bankruptcy. It often involves fairly boilerplate language, but it is binding on the debtor and the creditors. Because of the relatively high volume of these plans and their relatively routine nature, the IRS does not always pay sufficient attention to these plans. In Nomellini v. United States, the debtor pointed to his plan language and argued that it limited the federal tax lien filed against him. The district court affirmed a bankruptcy court determination holding that the plan did not disrupt the federal tax lien. The decision does not break new ground but does point to the potential power of confirmation to impact tax debts even if the discharge does not eliminate them.

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Mr. Nomellini owed taxes for several years and the IRS filed a notice of federal tax lien before he filed bankruptcy. In the bankruptcy case, the IRS filed a claim listing only $10,000 of its almost $200,000 claim as secured because the IRS adopted the values listed in debtor’s schedules showing his property and his secured creditors. The plan stated that “the valuations shown above will be binding unless a timely objection to confirmation is filed. Secured claims will be allowed for the value of the collateral or the amount of the claim, whichever is less…. The remainder of the amount owing, if any, will be allowed as a general unsecured claim paid under the provisions of paragraph 2(d).”

The plan made no mention of the IRS lien nor did it state that the IRS lien would be avoided. Although the debtor filed motions to value and avoid the liens of two other creditors, he did not do so with respect to the IRS lien. The plan provided that the real property owned by the debtor would re-vest to him at the time of the discharge or dismissal of the case. At the time of filing the bankruptcy case, the debtor valued his property at $950,000. Two years into the plan, the debtor asked for permission to employ a real estate agent and list the property for $1,800,000. Not long thereafter, the debtor obtained a contract for $2,175,000. I pause here to mention that this has never happened to me and I am jealous.

The debtor proposed that after paying off other debts based on their priority, over $1M of the sale proceeds would come back to the debtor. At this point, the IRS amended its claim to file a fully secured claim for $214,552 based on the NFTL it filed prior to the bankruptcy petition. The debtor objected to this amendment, arguing that the IRS was stuck with the plan language quoted above which limited its lien interest in the property.

The court found that the plan did not alter the lien rights of the IRS. While the plan binds the parties, the issue of what the plan covers still exists. It stated that a plan “should clearly state its intended effect on a given issue. Where it fails to do so, it may have no res judicata effect for a variety of reasons: any ambiguity is interpreted against the debtor, any ambiguity may also reflect that the court that originally confirmed the plan did not make a final determination of the matter at issue, and claim preclusion generally does not apply to a claim that was not within the parties’ expectations of what was being litigated, nor where it would be plainly inconsistent with the fair and equitable implementation of a statutory or constitutional scheme.” Citing In re Brawders, 503 F.3d 856, 867 (9th Cir. 2007).

The court also found that the debtor should have brought an adversary proceeding in which the IRS would receive adequate notice of the attempt to limit its lien if that was the debtor’s intention. Because the debtor did not make clear that his intention was to limit the IRS lien, the court would not allow him to limit the in rem rights of the IRS with respect to the property to which its lien had attached. Creditors should receive adequate notice of efforts to limit their liens. Putting cursory language in the plan is not an adequate method for providing notice. The court pointed to the court rules that the debtor should have followed if he wanted to limit the lien. These types of rules not only protect creditors with large numbers of claims like the IRS, but also protect creditors who only occasionally have a matter in bankruptcy.

The debtor also argued that the court valued the secured claim of the IRS at confirmation in order to determine the feasibility of the plan. The court finds that the claim was valued but not the lien interest and rejected this argument as well.

This case demonstrates that in the 9th Circuit, and I think in most circuits, debtors will not be allowed to attack a lien without giving a creditor specific notice of the attack. This is good news for creditors, and especially creditors like the IRS who have a lien interest on all of the debtor’s property and will not have a realistic mechanism for valuing all of that property within the tight time frames of a chapter 13 confirmation. If a debtor puts the IRS on notice that it wants to attack its lien interest, then the IRS can gear up for a fight in an adversary proceeding and decide whether the fight is worth the effort. Losing a lien interest based on the language of a plan puts the IRS and many other creditors in a tough spot.

The case also shows that sometimes debtors can come out of bankruptcy in good shape. This is certainly unusual, but I have seen other cases in which the value of debtor’s property jumped or was improperly valued at the outset. Here, the bankruptcy allowed the debtor some breathing room with respect to his property and he reaped the benefit of appreciation rather than a foreclosing lienholder. Even though the debtor lost the fight with the IRS, the debtor still made out very well in this case.

 

Clawback from IRS of Payment by Ponzi Schemers

In the case of Zazzali v. United States, the 9th Circuit has affirmed a lower court decision allowing the trustee in a bankruptcy of company that ran a Ponzi scheme to require the IRS to pay the money paid to it for taxes back to the bankruptcy estate for distribution to other creditors of the estate. The case involves Idaho’s Uniform Fraudulent Transfer Act as applicable through Bankruptcy Code section 544(b)(1), as well as the sovereign immunity provision of Bankruptcy Code section 106(a)(1). To win, the trustee needed to show that outside of bankruptcy an unsecured creditor could avoid the same transfer and that the sovereign immunity provision in the bankruptcy code did not prevent the ordering of a repayment from the government.

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The company that engaged in the Ponzi scheme was set up as an S Corporation. While operating and while running the Ponzi scheme, it made tax payments on behalf of its shareholders. It paid the IRS over $17 million during the years of the scheme and the primary beneficiaries of the payments were the two principal officers of the corporation. The IRS ultimately refunded to these two men over $3.6 million in claimed overpayments on their individual returns.

When the corporation filed bankruptcy and a trustee was appointed, the trustee began bringing fraudulent transfer actions to bring money into the estate for the benefit of the unsecured creditors. In addition to pursuing the company insiders, the trustee went after the IRS and 25 states to whom taxes were paid. The appeal only involves the IRS.

The trustee used both the fraudulent transfer provisions of Bankruptcy Code 544(b)(1) and 548. Section 548 is broader in scope but more limited in time. Under that provision, the trustee recovered $58,000 from the IRS paid within two years of the filing of the petition and the IRS did not contest that claim. Section 544(b)(1), which relies on the state provision for fraudulent transfers, allows the trustee to go back four years from the petition, and that was where the high dollar transfers occurred.

The IRS argued that Congress had not waived sovereign immunity with respect to the 544(b)(1) claim. The Seventh Circuit, in an almost identical case, ruled for the IRS in the case of In re Equipment Acquisition Resources, Inc., 742 F.3d 743 (7th Cir. 2014). The 9th Circuit reaches a different conclusion.

Section 106 lists the bankruptcy code sections for which sovereign immunity is waived. Section 544 is one of those sections. The 9th Circuit holds that the waiver in section 106 is absolute and gets past the IRS concern that the type of fraudulent conveyance at issue here is one derived from a state statute. The view of the IRS is that because the trustee here relied on 544(b)(1), and through it Idaho’s Uniform Fraudulent Transfer Act, the government’s sovereign immunity precludes a claim based on state law. To get past the IRS argument, the 9th Circuit, affirming the decisions of the district court and bankruptcy court below, looks at the bankruptcy code as a whole and how the two provisions at issue here fit into the overall scheme.

The sovereign immunity provision at issue here was enacted after the enactment of section 544. This suggests that Congress knew what it was doing when it put 544 into the list of provisions for which sovereign immunity was waived and did not back into this situation.

The 9th Circuit also found that the IRS interpretation of section 106 and the interplay of the sovereign immunity provision there with the fraudulent transfer provision in 544 would nullify a portion of the statute. Using a rule of statutory construction, the 9th Circuit found that this interpretation should be avoided if possible, and here it is possible if the waiver of sovereign immunity is read broadly.

The 9th Circuit acknowledged that its opinion is at odds with the only other circuit court opinion and it writes further to explain why its interpretation is the better one. (Perhaps anticipating that the circuit split will result in Supreme Court review.) The 7th Circuit rests its opinion in the Equipment Acquisition case, upon the ground that private creditors could not use the state fraudulent conveyance statute to pry money out of the federal government. It viewed the trustee as standing in the shoes of the state creditors and did not believe that the broad statement in section 106 was intended to change non-bankruptcy law in such a way that allowed the trustee to have state law powers no private creditor had outside of bankruptcy.

The 9th Circuit finds that this is exactly what Congress intended when it passed the broad waiver of sovereign immunity. It recognized the unique position of the bankruptcy trustee and the need to recover money for the bankruptcy estate in a federal proceeding, albeit one based upon state law.

In addition to the argument regarding sovereign immunity, the IRS also argued, in line with the reasoning of Equipment Acquisition, that the 9th Circuit’s interpretation ran afoul of the Appropriations Clause and the Supremacy Clause. These provisions would potentially stop a private creditor outside of bankruptcy even if sovereign immunity did not. The 9th Circuit says no Appropriation Clause violation exists because the trustee is not taking money out of the Treasury but rather recovering money where a transfer is “voidable under applicable law.” With respect to the Supremacy Clause concerns, the 9th Circuit finds that because bankruptcy is a federal cause of action, this situation is not a state wielding power over the federal government.

I do not know if the IRS will pursue this issue into the Supreme Court but would not be surprised if it did. There is a fair amount of money in this case and these types of cases sadly come up with some regularity. The result here is not one that bothers me from an equitable standpoint. It does not seem right for the IRS to keep money stolen from individuals where the tax is essentially a tax on the ill-gotten gains. I feel better if the money goes back to the individuals who suffered the loss and the IRS does not receive what amounts to a type of windfall. Sometimes victims or agencies representing the victims make constructive trust arguments in these types of situations. Whatever the argument, it makes sense to try to get the money back to the victims if possible. I hope that the litigation does not cause all of the money to end up in the hands of the lawyers to the exclusion of the victims.

 

Late Filed Return Issue Overlooked in Recent Collection Due Process Case

On July 28, 2017, in the Collection Due Process (CDP) case of Conway v. Commissioner, Docket Number 6204-13S L, the Court issued an order determining that petitioner did not discharge her tax liabilities for several years.  The Tax Court has the authority Washington v. Commissioner, 120 T.C. 114, 120-121 (2003) to determine discharge issues in CDP cases.  The case is interesting for what the IRS did not argue, what it conceded, the standard of review of a CDP case in the 1st Circuit and how timing plays into the outcome.

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Ms. Conway failed to timely file returns for the years 2002 and 2006-2010.  This familiar story lands her in bankruptcy court for the District of Massachusetts on February 10, 2012 where she received a discharge of her chapter 7 case on May 8, 2012.  Regular readers of this blog know that someone living in the First Circuit who does not timely file their income tax return can never discharge the liability on that return because of the decision in Fahey v. Massachusetts Department of Revenue, _ F.3d _ (1st Cir. February 18, 2015).  See blog posts here, here and here discussing the issue.

The funny thing about the Conway decision is that even though Ms. Conway failed to timely file her returns for all of the years at issue and even though controlling circuit law, under the Golsen rule, made the outcome of her case a slam dunk victory for the IRS, the Fahey case never gets mentioned.  This could be because the people involved were not carefully reading PT, or for other reasons, or a combination of both.

After Ms. Conway received her discharge, the IRS did not abate her liabilities for the years mentioned above.  At that time, almost three years before the Fahey decision, a decision with which the IRS does not yet agree, the IRS decision to keep open her liabilities for these years was not based on her late filing but on the timing of the assessments for the years 2006-2010 and on a mistake as to 2002.  In August, 2012 the IRS filed a notice of federal tax lien against her for her outstanding liabilities and sent her the required CDP notice.  She timely filed a CDP request and sought relief, inter alia, because the tax debts were discharged in her recently completed bankruptcy case.  In February, 2013 the Settlement Officer (SO) issued a notice of determination sustaining the NFTL.

Ms. Conway filed a CDP Tax Court petition on March 15, 2013 raising, inter alia, the bankruptcy discharge as a reason for removing the NFTL.  The IRS filed a motion for summary judgment on November 29, 2013.  In that motion, the IRS conceded that the SO made a mistake as to 2002 and should have written off that liability; however, the IRS argued that as to the remaining years the exception to discharge in Bankruptcy Code 523(a)(1) prevented the discharge.  (The IRS attorney pledged to fix the 2002 year and make sure it was abated.) The IRS argued that the “SO did not abuse her discretion under the standard of review adopted by the United States Court of Appeals for the First Circuit in Dalton v. Commissioner, 682 F.3d 149 (1st Cir. 2012), rev’g 135 T.C. 393 (2010).”  On January 6, 2014, petitioner filed an objection to the motion for summary judgment.  At that point, the case stood ready for decision and at that point Fahey was just a glimmer in the eye of the Massachusetts Department of Revenue.

The Court decides in Conway that the 2006-2010 taxes are excepted from discharge because they were assessed within 240 days of the date of filing the bankruptcy petition.  If taxes were at all a factor in the decision to file bankruptcy, and I have no idea, I fault taxpayer’s bankruptcy lawyer for filing during this 240-day window because it prevents them from discharge under 523(a)(1)(A) since these taxes still had priority status; however, even in the pre-Fahey world, she would have had to wait two years after filing her late returns in order to avoid the exception from discharge under 523(a)(1)(B).  The Tax Court had ample reason to find her taxes excepted from discharge here and was correct in doing so.  At the time the IRS filed its summary judgment motion, it was correct to concede 2002 and it was correct not to argue Fahey.

Because the Tax Court took over three and ½ years to decide what appears to be a relatively simple discharge case, the IRS had the opportunity to supplement its summary judgment motion with the intervening Circuit authority.  Based on the docket sheet of the case and the Court’s opinion, it appears that it did not do so; however, the IRS did file a request to file a status report earlier this year and I cannot see what was in that request.  I thought that the IRS, even though not agreeing with the one-day late discharge rule of Fahey and two other circuits, was making the argument in the three circuits with controlling authority on the one day late rule.  So, I do not know if the failure to point Fahey out to the court here was a decision representing a change in position that it would argue the one-day late rule in those circuits, or a failure to recognize the opportunity to make this argument, or simply a decision that it was going to win anyway and why add yet another reason when the opinion should come out at any second.  I bring it up for those watching the one day rule and the IRS reaction to it.  Because of the decision in the Fahey case, the IRS decision to concede 2002 could have been reversed.  I do not know how the Tax Court would have reacted to an effort by the IRS to withdraw its concession because the law of the circuit changed while the Tax Court was working on its opinion.  Because the IRS did not attempt to withdraw its concession, we will never know.

The case also raises the application of the First Circuit’s decision in Dalton.  In Dalton, the First Circuit reversed the Tax Court and held that the findings of law in CDP determination are only tentative and so the Tax Court does not need to give deference to the SO’s legal conclusions.  The IRS argued in its motion that despite the SO’s legal mistake as to the dischargeability of 2002, the Court should sustain the notice of determination because the SO did not abuse her discretion under the standard of review adopted in DaltonDalton seems to stand alone in its view of the deference accorded to SOs.  This issue deserves attention and may get litigated further in other circuits.

Ms. Conway was going to lose her case even before the Fahey decision because of the timing of her late filed returns and her bankruptcy petition.  She benefits here by filing her case before the Fahey decision came out because of the IRS concession with respect to 2002.  She loses most of her case because of late filing.  Somehow taxpayers need to understand the benefits of filing on time even if they cannot pay.  In circuits like the First, it is now critical because it is a lifetime bar on discharge.  Even in other circuits, late filing will create the types of problems Ms. Conway faced here and will not allow debtors to obtain the full measure of the benefits of bankruptcy.

 

Litigating Your Innocent Spouse Claim in Bankruptcy

If you were interested in yesterday’s post concerning the mismanagement over a period of years of the account of Mr. Fagan, please read the comment posted yesterday by Bob Kamman.  Bob took the time to call Mr. Fagan and get the kind of background details not possible to find by just reading the opinion.  Based on the information from Mr. Fagan, his efforts to fix the problem in TAS, Appeals and Chief Counsel where he was working face to face with a real human were totally unsuccessful.  This is the type of case I expected Senator Roth to find in his hearings before the 1998 legislation.  These cases exist because sometimes accounts get badly mangled.  I did not expect to see Chief Counsel litigating such a case.  From the comments it appears that accounts management was not the only place badly managed on this case.

In March, the bankruptcy court for the Southern District of Texas ruled in In re Pendergraft that it had jurisdiction under Bankruptcy Code 505(a) to determine whether Jane Pendergraft qualified for relief from her joint and several liability under IRC 6015(f).  The IRS strenuously objected to the bankruptcy court’s decision that it had the power to decide she qualified for innocent spouse relief.  It views the Tax Court as the exclusive avenue for obtaining such relief.  The case, which maybe the first case to decide this issue – at least the first one to decide the case favorably to the taxpayer, deserves attention because it may open up opportunities for relief in a forum previously unused for this purpose and because the of policy tensions that support the bankruptcy court’s decision even if the language of the statute may not.

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Section 505(a) of the bankruptcy code offers taxpayers in bankruptcy the opportunity to contest their tax liabilities in that forum instead of the more traditional forums of Tax Court, district court, or Court of Claims.  The reason that Congress granted this power to the bankruptcy court is that sometimes the tax liability needs to be final in order to the bankruptcy case to move forward.  The time frame for deciding a tax case in the other forums does not necessarily match the time frame for the bankruptcy case.  By giving the bankruptcy court the ability to decide the tax matter, Congress allowed it to control the timing.

The reasoning behind the grant of jurisdiction to the bankruptcy court to hear the tax matter extends to the determination of innocent spouse status; however, the decision of whether someone is an innocent spouse does not turn on whether the tax is due, i.e., the merits of the liability, but rather whether this person claiming innocent spouse status should be relieved of the liability even though it is due.  The IRS argues that this distinction precludes the bankruptcy court from deciding the innocent spouse issue because its authority under section 505(a) covers determining the merits of the liability and does not extend to the issue of innocent spouse status even though such a determination would clearly have an important outcome on a taxpayer’s bankruptcy case and whether the debtor could confirm a plan.

The facts of the case are not unusual for an innocent spouse argument.  Mrs. Pendergraft, who was 66 at the time of the decision, married Mr. Pendergraft in 1988.  During the period of their marriage, they split household responsibilities with Mr. P taking on “exclusive responsibility for the financial activities of the homestead, including the preparation and paying of taxes.”  Mrs. P operated a private psychotherapy practice part time and took primary responsibility for child care and household maintenance.  For the years 2001-2006, the Pendergrafts failed to file tax returns or to pay the taxes.  Mrs. P alleged that she did not know of the failures and signed returns for each year expecting her husband to file them.

She learned of the problem when the IRS levied on her separate bank account in 2008.  Although Mr. P initially denied knowledge of the problem he eventually confessed to her he had forgotten to pay the taxes for one year.  He later informed her that he had retained attorneys and accountants to fix the IRS problem, that the agreement required they pay the IRS $10,000 a month for an extended period, and that he would make sure all future returns were timely filed.  She alleged that he may have misappropriated money she gave to him between 2008 and 2016 to deal with the IRS and that he caused the IRS to mail all correspondence to his office address preventing her from learning of ongoing problems.

In late June 2016, she attended a meeting with their attorney in which she alleges that she learned for the first time that their income and property taxes had not been paid for 15 years and that they faced criminal prosecution.  According to her, this attorney advised her that she must join her husband in filing for bankruptcy in order to prevent the IRS from seizing their house and from prosecuting them.  I note that if the attorney gave such advice, it incorrectly described the effect of bankruptcy on possible criminal tax prosecution.  Bankruptcy code section 362(b)(1), one of the exceptions to the automatic stay, provides that bankruptcy has no impact on criminal prosecution.  By October of 2016, she had obtained permission of the bankruptcy court to proceed with divorce and in November she asked the bankruptcy court to determine that she qualified as an innocent spouse.  The IRS filed a motion to dismiss the request for an innocent spouse determination arguing ‘that a bankruptcy court’s jurisdiction is limited by the fact that it is a judicial offer of the district court, that the structure of 26 U.S.C. 6015(f) vests the determination of innocent spouse relief strictly in the IRS and tax courts, and that the United States has not consented to being sued on the innocent spouse issue in bankruptcy court.”

The bankruptcy court looked at section 6015(e)(1)(A) which allows a court to grant innocent spouse relief if the IRS fails to make a determination within 6 months.  The bankruptcy court pointed to the language of the statute providing that the remedy available in Tax Court for innocent spouse determinations is “[i]n addition to any other remedy provided by law.”  Bankruptcy section 505(a) is another “remedy provided by law.”  The bankruptcy court looked at applicable 5th Circuit law on the application of section 505(a) which it found supported the court’s ability to make an innocent spouse determination.  The court acknowledged the case law cited by the IRS finding bankruptcy court an inappropriate forum for innocent spouse determinations.

The bankruptcy court rejected the authorities provided by the IRS for three reasons: 1) the case law did not address 5th Circuit precedent interpreting 505(a); 2) the plain language of the statute; and 3) a decision by the bankruptcy on this matter would not lead to inconsistent judgments or conflict with basic principles of judicial economy.

Having decided that it can decide the innocent spouse issue, the bankruptcy court then determines that it must wait for the IRS to make a decision.  It required Mrs. P to submit to the IRS Form 8857 and indicated that it will make a decision if the IRS fails to do so in six months (not adopting the four-month rule for claims for refund as the shortened time period in 505 cases) or after the IRS makes an adverse decision.  It is possible, of course, that the IRS will decide in her favor in the administrative process.  If it does not, watch this case as I expect the IRS will not give up this issue at the bankruptcy court level.  We looked quickly at the bankruptcy case  and did not see any developments yet on this issue.

 

 

Another Circuit Weighs in on the Discharge of Unfiled Returns

We have discussed how courts, IRS and debtors are struggling with Bankruptcy § 523(a) and its infamous hanging paragraph. Addressing exceptions to discharge that language states the term ‘return’ means a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements). A number of courts have held that unless a return is filed by the appropriate due date, the tax liability is not eligible for discharge; other courts have pushed back on the one-day rule.

In Giacchi v. United States, the Third Circuit continued a trend away from the one-day rule and held that the debtor’s taxes were non-dischargeable based on the application of the Beard test.  Following the pattern of other recent cases on this issue discussed here and here, the Third Circuit stated that it did not need to reach the one-day rule because it found that the Forms 1040 filed by Mr. Giacchi after the IRS had already assessed the taxes based on IRC 6020(b) determination of the liability and a failure by Mr. Giacchi to petition the Tax Court in response to a statutory notice of deficiency were not a genuine effort to file a tax return but were simply forms filed to qualify Mr. Giacchi for discharge.  Of course, the Court could have avoided having to make the determination based on the valid return issue if it had decided based on the one-day rule.  So, the decision, like the recent decisions in other circuits, serves as an implicit repudiation of the one-day rule even though the Third Circuit does not directly take on the statutory language and seek to resolve the issue directly.

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As discussed before, the resolution of the issue in the manner in which the Third Circuit resolves this case does little to fix the problem the IRS has of administering discharges to determine when it may write off tax liabilities.  The Court did not adopt the bright line rule sought by the IRS that would make any Form 1040 filed after the IRS makes an IRC 6020(b) assessment unqualified to meet the test of a return; however the Court comes about as close as you can come to setting out that conclusion without explicitly doing so.  The case presents a strong victory for the IRS and will prevent just about any taxpayer in the Third Circuit from getting a discharge once the IRS makes an IRC 6020(b) assessment.

The facts of this case follow the normal fact pattern for someone filing a late return and seeking discharge.  He failed to file returns for 2000, 2001, and 2002.  In 2004, the IRS prepared substitute returns for 2000 and 2001, sent him a statutory notice of deficiency, he defaulted on that notice and then filed the Forms 1040 for 2000 and 2001 about one month after the IRS assessed the taxes based on the defaulted notice.  The only thing unusual about these facts is how quickly he filed the returns after the assessment.  The assessment would have triggered a notice and demand letter but he should also have received several letters leading up to and including the notice of deficiency.  So, it is not clear why the notice and demand letter would have prompted action.  The IRS went through the same process for the unfiled 2002 return.  It ended up assessing that liability in 2005 and he filed the delinquent Form 1040 in 2006.  He filed a chapter 7 bankruptcy in 2010.  When the IRS did not remove the tax liabilities for these three years, he then brought an adversary proceeding against the IRS seeking to have the court determine that the taxes were discharged.  The bankruptcy court and the district court held the taxes were excepted from discharge.

Mr. Giacchi made three arguments which the court rejected in relatively short order.  First, he argued that the filing of the returns represented an honest attempt to comply with the tax law.  In rejecting this argument, the Third Circuit specifically declined to follow the Eighth Circuit decision in Colsen v. United States, 446 F.3d 836 (8th Cir. 2006).  This repudiation of Colsen definitely benefits the IRS as it tries to consolidate the Circuit court opinions and the reasoning, similar to the Fourth Circuit’s decision in In re Moroney, 352 F.3d 902, 905-6, leaves little room for any taxpayer who files a Form 1040 after an IRC 6020(b) assessment.

Second, Mr. Giacchi argued that because his late filed Forms 1040 showed less taxes than the amounts assessed by the IRS and the IRS abated the taxes down to the amounts on the late filed returns, the documents had meaning and should be treated as returns.  This situation almost always arises when taxpayers file the late Forms 1040.  The court noted that he should not benefit just because the IRS made an imprecise estimate of his liability (and because it abated his liabilities in response to the late filed Forms 1040.)

Lastly, Mr. Giacchi argued that he should be excused because of his emotional state during the years.  The Court did not describe his emotional state.  In effect, Mr. Giacchi seeks an IRC 6511(h)-like suspension of the time to file due to his incapacitating emotional condition.  The Court suggested that under the right circumstances someone might be able to demonstrate a good faith effort to comply with the tax laws but his emotional state did not fit the bill.

Unless Mr. Giacchi succeeds in convincing the Supreme Court to take his case, the circuit split between the three “one-day rule” circuits, the Eighth Circuit in Colsen and the five or so relatively pure Hindenlang circuits will persist.  Look at earlier posts here, here, and here for a greater discussion of this issue.

Almost immediately after the Giacchi decision, a bankruptcy court in the Northern District of California cited to the Giacchi decision favorably in the case of Van Arsdale v. Internal Revenue Service.  Mr. Van Arsdale, whose facts were essentially similar to the Giacchi facts, argued that he panicked because he did not have enough money to pay his taxes for the year at issue and then he stuck his head in the sand until after the IRS made the assessment.  In citing to Giacchi, the bankruptcy court found that this explanation, without more, simply did not help.  The Ninth Circuit decision in In re Smith, 828 F.3d 1094 (2016) sets up a test similar to the one adopted by the Third Circuit.  The decision in Van Arsdale was very predictable based on circuit precedent but shows continuing attempts to seek discharge even in circuits that have recently made pronouncements on this issue.

False Return Conviction Provides Basis for Collateral Estoppel to Prevent Discharge

For a brief period the Tax Court treated a conviction for filing a false return, IRC 7206(1) as the basis for sustaining the civil fraud penalty using collateral estoppel.  The period ran from the decision in Considine v. Commissioner, 68 T.C. 52 (1977) to its reversal in Wright v. Commissioner, 84 T.C. 636 (1985) (reviewed).  In the recent unpublished bankruptcy appellate panel (BAP) case of Terrell v. IRS, BAP No. WO-16-007 (Bankr. 10th Feb 17,2017), the 10th Circuit BAP sustained the decision of the bankruptcy court and held that a guilty plea for filing a false return provides the basis for collaterally estopping the debtor from challenging the discharge of his taxes for the year of the plea.  Though unpublished, the opinion, without much analysis, pushes the scope of collateral estoppel on the issue of criminal conviction and civil fraud toward a more favorable position for the IRS.  Reasons exist for drawing a distinction between collateral estoppel in the bankruptcy discharge context and civil fraud penalty.  Had the court articulated those reasons, I would have come away from the opinion with a more comfortable feeling.

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The Tax Court opinions, cited above, determining first that collateral estoppel applies to civil fraud and then subsequently determining it does not provide lengthy analysis concerning the scope of a false return plea.  From the perspective of punishment both tax evasion, IRC 7201, and filing a false return will get the taxpayer to the same prison sentence almost every time.  Because the elements of the two crimes differ slightly and because proving the filing of a false return is slightly easier, prosecutors lean towards a false return conviction at times. Chief Counsel attorneys used to complain bitterly when Assistant United States Attorneys would accept a plea to a false return count rather than evasion because it meant a lot more work in the subsequent civil case; however, the change to 6201(a)(4) to allow assessment of the restitution amount may have taken some of the sting off of the situation.

The difference in the elements of the two crimes plays a role in deciding whether collateral estoppel applies.  The Tax Court examined this difference closely in its opinions applying the elements of the crimes to the civil fraud penalty while the BAP does not do spend as much time applying the elements of the crime to the elements of the applicable discharge statute.

In Considine the Tax Court reasoned:

(a) that it had previously held that a conviction for willfully attempting to avoid tax (I.R.C. § 7201) established fraudulent intent justifying a civil fraud penalty, see Amos v. Commissioner, 43 T.C. 50, aff’d, 360 F.2d 358 (4th Cir. 1965); (b) that the Supreme Court had held that “willfully” has the same meaning in section 7206(1) (false return) as in section 7201 (attempt to evade tax), see United States v. Bishop, 412 U.S. 346, 93 S.Ct. 2008, 36 L.Ed.2d 941 (1973); and (c) therefore that a conviction for filing a false return, without more, establishes fraud justifying the civil penalty.

Considine v. United States, 683 F.2d 1285, 1286 (9th Cir. 1982)(the 9th Circuit criticizes the Tax Court’s decision in citing to Considine v. Commissioner, 68 T.C. at 59-61)

In reconsidering and reversing Considine, the Tax Court in Wright stated:

“In a criminal action under section 7206(1), the issue actually litigated and necessarily determined is whether the taxpayer voluntarily and intentionally violated his or her known legal duty not to make a false statement as to any material matter on a return. The purpose of section 7206(1) is to facilitate the carrying out of respondent’s proper functions by punishing those who intentionally falsify their Federal income tax, and the penalty for such perjury is imposed irrespective of the tax consequences of the falsification. As noted above, the intent to evade taxes is not an element of the crime charged under section 7206(1). Thus, the crime is complete with the knowing, material falsification, and a conviction under section 7206(1) does not establish as a matter of law that the taxpayer violated the legal duty with an intent, or in an attempt, to evade taxes.” (internal citations omitted)

The IRS Chief Counsel’s office at page 63 of its Tax Crimes Handbook states that “there is no collateral estoppel as to civil fraud penalties under this section. The section 7206 (1) charge is keyed into a false item, not a tax deficiency. Collateral estoppel arises only with a conviction or guilty plea to tax evasion.”  Similarly, IRM 25.1.6.4.3 provides that “A conviction under IRC 7206(1), filing a false return, does not collaterally estop the taxpayer from asserting a defense to the civil fraud penalty since conviction under IRC 7206(1) does not require proof of fraudulent intent to evade federal income taxes. In these cases, additional development is required to establish the taxpayer’s intent to evade assessment of a tax to be due and owing.”

At issue in Terrell is whether the his guilty plea for a false return places him squarely within the elements of 523(a)(1)(C).  Section 523 of the bankruptcy code sets out the actions with respect to individual debtors that prevent, or except, the discharge of a debt.  Congress has added to the list over the years since the adoption of the bankruptcy code in 1978.  The list of excepted debts in 523 numbers 19 and several of those 19 subparagraphs of section 523(a) have more than one basis for excepting the debt from discharge.

The provision relating to tax debts, 523(a)(1), has three separate bases for excepting a debt from discharge.  Subparagraph (A) excepts debts that achieve priority status under section 507(a)(8).  This subparagraph, in general terms, prevents debtors from discharging relatively new tax debts.  Subparagraph (B), which has been the subject of many posts, prevents debtors from discharging tax debts for which the debtor has never filed a return or filed a late return within two years of the filing of the bankruptcy petition.  Subparagraph (C) at issue in this case prevents debtors from discharging tax debts “with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.”

The question before the BAP concerns the language of the discharge exception for making a fraudulent return and the language of IRC 7206(1) for filing a false return.  Section 7206(1) holds a taxpayer liable for a felony tax offense if he “willfully makes and subscribes any return, statement, or other document, which contains or is verified by a written declaration that it is made under the penalties of perjury, and which he does not believe to be true and correct as to every material matter.”  Does this statute, which does not require any understatement of tax but merely a false statement, match the elements of bankruptcy code section 523(a)(1)(C) such that the conviction under IRC 7206(1) requires a finding of collateral estoppel regarding the discharge of the underlying taxes.

The BAP, after acknowledging that Mr. Terrell presented “no arguments as to why the bankruptcy court’s application of collateral estoppel was in error” says yes because (1) “the issue in the Criminal Case is identical to the issue presented in the Adversary Proceeding” because the same factual issues existed in both statutes; (2) his “guilty plea in the Criminal Case constitutes a full adjudication on the merits”; (3) both the debtor and the IRS were parties to the criminal case; and (4) the debtor “had a full and fair opportunity to litigate the Criminal Case.”

The language in 523(a)(1)(C) “made a fraudulent return” may sufficiently line up with the language of IRC 7206(1) to allow collateral estoppel to work here but I would like the court to work a little harder to make that connection for me.  The Tax Court eased into a similar conclusion with respect to the fraud penalty and an IRC 7206(1) conviction and then had to walk it back after the 9th Circuit brought its attention to the elements of that crime.  The standard of proof for the IRS in a 523(a)(1)(C) case is preponderance of evidence unlike the clear and convincing standard needed for sustaining the civil fraud penalty.  There are certainly differences between the Considine situation and the Terrell case but enough similarities to deserve more analysis.  I am not yet convinced.

Does Failure to List a Refund Claim in a Debtor’s Bankruptcy Schedules Provide the IRS a Defense Barring the Refund

The case of Martin v. United States (C.D. Ill 1-5-2017) examines the jurisdictional objection raised by the Department of Justice Tax Division to a claim for refund filed by taxpayers who went through a chapter 7 bankruptcy proceeding prior to filing the claim for refund.  The bankruptcy proceeding matters because the refund claims here relate to pre-bankruptcy petition years.  Because the refund claim existed at the time of the bankruptcy, the claim became property of the bankruptcy estate under B.C. 541.  The taxpayers had a duty to list all of their property and rights to property when they entered bankruptcy.  The taxpayers did not list the refund claims on their bankruptcy schedules and did not file the refund claims until just prior to closure of their bankruptcy case in 2005.

In this case, the IRS seeks to knock out their claim because of the failure to list it in the bankruptcy proceeding regardless of the merits of the claim.  The position of the IRS has a sound basis.  The district court does not dismiss the refund claim but discusses several theories raised by the IRS.  The court signals that it may dismiss the claim once it acquires more facts.

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I first saw this issue almost 30 years ago in a Third Circuit case Oneida Motor Freight, Inc. v. United Jersey Bank, 848 F.2d 414 (3rd Cir. 1988). Citing to In Re Hannan, 127 F.2d 894 (7th Cir.1942), the Court stated

“a long-standing tenet of bankruptcy law requires one seeking benefits under its terms to satisfy a companion duty to schedule, for the benefit of creditors, all his interests and property rights.”

The Court also pointed to the debtor’s statutory duty stating

“Section 521 of the current Bankruptcy Code outlines a non-exhaustive list of the debtor’s duties in a bankruptcy case. Foremost for our purposes, the debtor is required to ‘file a … schedule of assets and liabilities … and a statement of the debtor’s financial affairs….’”

Oneida argued that at no point in the bankruptcy case prior to the time it filed its action against the bank did the right moment exist to bring such an action.  The Court gave little weight to this argument stating

“Although Oneida may be technically correct in its argument that it was never procedurally compelled to raise its claim, we are satisfied that its failure to mention this potential claim either within the confines of its disclosure statement or at any stage of the bankruptcy court’s resolution precludes this later independent action. Even absent a specific mandate to file a counterclaim, complete disclosure is imperative to assist interested parties in making decisions relevant to the bankrupt estate.”

In Oneida, the debtor brought a suit against a bank for breach of duty but failed to list the chose in action in its schedules and failed to mention it in its plan of reorganization.  Because Oneida was a chapter 11 case, it presents a slightly different setting than Martin but most of the principles remain the same.  I should also note that there was a vigorous dissent in Oneida pointing out the negative impact to the estate of barring the suit against the bank.

The issue presents the question of fair play.  The law has some doctrines that apply when a party fails to treat others properly while seeking benefits for themselves.  By failing to list the claim for refund, which exceeds $100,000, the taxpayers here misled their creditors regarding the amount of assets available from the bankruptcy estate.  The creditors received distributions from a bankruptcy estate that did not include all of the assets owned by the debtors.  Based on those facts, it seems unfair to allow the debtors to benefit, in this case to substantially benefit, from their own failure to properly file their schedules which they signed under penalties of perjury.  I acknowledge that it is possible that at the time of filing the schedules they may not have been aware of the existence of the refund claim but that still raises a question of whether the timing of their becoming aware of an asset is the controlling event for a determination of who should benefit.

A logical way to prevent the debtors from benefiting would be to deny their claim, but there is more to the story.  I want to paint a fuller picture of fairness before I go back to the doctrines examined by the Court.  Here, the debtors in Martin did go back to the trustee and notify him of the possible refund many years after the closing of the bankruptcy case.  The trustee did seek to find and notify the creditors of the estate but none stepped forward to renew their claims.  I did not go and pull the schedules in this case to see what kind of payout occurred from the bankruptcy estate, how many creditors existed, what type of creditors existed, etc.  Depending on the type of creditors and the distance in time between the close of the case and the correspondence from the trustee, it is almost certain that the creditors had written the taxpayers’ accounts off several years prior to the inquiry from the trustee about a possible additional distribution.  If they looked back on their computerized accounts they may have seen that no liability was due from the debtors and may not have had a good way to recreate the account.  The creditors had a duty to write off all dischargable debt in order to avoid violating the discharge injunction imposed by the bankruptcy code and would have taken steps to do so many years before the trustee wrote to them.  If the creditors had not taken immediate steps to write off the debt following discharge, they would have incurred the significant penalties that arise when it is violated.  While it is easy to question why the creditors of the taxpayers’ bankruptcy estate did not raise their hands and request the money when given the opportunity to do so, it may not have been easy or possible for them to identify the debt so long after writing it off.  Because no creditor came forward to ask that their long forgotten debt be paid, the trustee told the bankruptcy court that no creditor of the estate had an interest in the taxpayers’ pre-bankruptcy refund even though it was potentially a six figure refund and even though the creditors probably got paid only a fraction of what they were owed.

First, the taxpayers allege that they did not know of the refund claims until 2005.  If they did not allege this, or at least allege that they did not know of the claims at the time they filed their bankruptcy petition and the attendant schedules under penalty of perjury, they would risk prosecution.  By bringing the refund action and exposing their failure, the debtors would know that this issue would arise.  Without knowing more, I believe them that they were unaware of the refunds at the time of filing their bankruptcy petition because of the defense such belief provides to the possible prosecution for bankruptcy fraud.  So, their failure to list the refund claims may well have resulted not from an effort to deceive their creditors but rather from a desire to claim a benefit once discovered.

Second, the IRS, assuming the taxpayers’ refund claim deserves acceptance, would itself become the beneficiary of a windfall at the expense of the debtors pre-bankruptcy creditors should the court deny the debtors the refund under a theory that no pre-bankruptcy refund could ever be paid if not listed in the schedules.  Unlike the Oneida case, in which the unlisted asset the debtor sought to later recover was against a creditor of the estate, nothing in the facts suggests that the IRS had an unpaid claim in the bankruptcy case.  Should the remedy for a situation such as this provide a windfall to the IRS as it argues?  While the IRS might receive a windfall, it did nothing wrong.  The denial of the refund would result from the debtors’ failure and not due to any actions by the IRS.

Third, maybe an appropriate remedy in a case like this should not allow debtors or the IRS to reap a benefit that, had debtors submitted a timely claim, would have gone to the creditors.  Perhaps a doctrine such as Cy Pres should apply to send the funds to a deserving charity.   The equities at issue here do not favor the debtor even though the debtor did eventually go back to the trustee and bring up the existence of the claim.  It will be interesting to see what remedy the bankruptcy court fashions out of the mess created by the failure to list an asset.  Because the debtors may not have had a good way to identify the refund at the time of filing their bankruptcy petition, the debtors here do not have the same level of culpability that the debtor in the Oneida case had because the cause of action against the bank in the Oneida case would have something that debtor knew or should have known existed at the time of filing the schedules and at the time of presenting a plan of reorganization.  With tax refunds, the existence of the refund sometimes does not become clear for some period after the refund potentially arises, what is a fair method of dealing with parties when such an even occurs.  Maybe Martin will shed some light on the best answer.